Level 3 Fair Value Measurement and Systemic Risk

Motivated by bank regulators’ use of level 3 fair value assets as an indicator for systemic risk, we examine whether level 3 fair value assets contribute to systemic risk buildup via the balance sheet liquidity channel and how financial reporting transparency mitigates the risk buildup. We first document increased loss hoarding for banks with more level 3 assets. We then find that level 3 assets contribute to systemic risk buildup for banks with high repo liabilities but low liquid assets. Importantly, we find additional disclosures of valuation inputs mitigate level 3 assets’ contribution to systemic risk. Finally, our results show that banks with security impairment losses reduce repo financing and increase asset sales. Collectively, the evidence suggests that sudden collateral value reductions related to level 3 fair value assets may serve as the origin of a liquidity shock that trickles down the financial system, thereby building up systemic risk. This study contributes to the financial stability and fair value accounting literature by exploring the role of fair value measurement in banks’ liquidity management, which is distinct from the regulatory capital channel examined by prior research